Corporate governance considerations for fund managers
Just over four years ago, I embarked on a research project looking at corporate governance in private equity-backed companies. When I started to talk to industry insiders about the project, a surprisingly high number quipped: “That won’t take long!”
Although a little disheartening to an enthusiastic student in search of material to study, those private equity veterans were making an important point: there is very little external regulation of corporate governance in the private companies they back, and the boards they sit on do not spend hours ticking compliance boxes. Away from the regulation and constant scrutiny of uninformed outsiders that is associated with the public markets, private equity firms can get on with what they do best: building better companies.
But, fortunately for my project, those insiders were also wrong. Corporate governance, at least in the broad sense in which I defined it, is something that the private equity industry does, and – on the whole – does very well.
That lack of external regulation means that shareholders and managers (and lenders and other critical stakeholders) can negotiate and build the corporate governance systems that work for their business, at its particular stage in its life cycle and with its particular strategic goals and available resources. I was able to plot the ways in which private equity boards improve the quality of decision-making, protect the company from downside risks, and guard the reputation of the fund and its investors. I heard many stories demonstrating that significant value is created (or protected) by corporate governance mechanisms. In fact, I was left with the distinct impression that strong corporate governance is a strong driver of outperformance in the private equity sector, and one that is under-emphasised by the existing academic research in the area.
My research focused exclusively on portfolio companies. I did not look at fund manager governance processes at all. But I am now often asked whether private equity fund managers, who – even if they don’t do it consciously – build sophisticated governance systems in the companies they back, do the same for their own businesses. And, at a time when regulators are increasingly focused on substance and risk management, the question is becoming more salient. So, are private equity firms imposing processes on their portfolio companies that they don’t adopt themselves?
There is, of course, a very long list of questions that a private equity firm could ask if it wanted to examine whether best practices in corporate governance are embedded in its own systems – perhaps beginning with whether an external eye could add constructive challenge to decision-making, avoid group-think and help protect the firm’s core values. But I want to examine two specific issues: stakeholder voice, and regulatory risk mitigation – both topical, and both highly material in our industry.
Managing for stakeholders
Board members are well aware that stakeholder views are a vital input into any major strategic decision. No self-respecting director would make a fundamental business decision without considering the impact of that decision on the company’s key stakeholder groups, whether that is employees, customers or shareholders (and, in fact, UK law demands that they do). A key question therefore is whether the private equity firm’s board fully understands the views of the GP’s key stakeholders? Has the board defined who those stakeholders are, and worked out a mechanism to accurately deliver their perspectives to the full board?
Clearly investors are likely to be the most important stakeholder group for a private equity fund manager, and the Managing Partner, or Chairman, is probably in touch with investors on a pretty regular basis. But is there someone on the board who is specifically responsible for making sure that any key decision is one that makes the firm more attractive to this vital stakeholder group? Is there a board member responsible for consulting regularly with the investors and bringing their views back to the boardroom table? Are all firm decisions examined through the investors’ lens?
Regulatory risk mitigation
Any investment committee will expect a portfolio company’s regulatory risks – especially those identified in the pre-acquisition due diligence, but also any that crop up during the private equity firm’s period of ownership – to be identified by and pro-actively managed by the board. That is not to say, of course, that the board will be expected to draft the policies and procedures that are needed to mitigate the risk of a corruption scandal, or a fatal workplace accident. But the board’s job is certainly to make sure that someone is on top of those issues, not least because board members can find themselves liable for a failure by the company to comply with the law if they have neglected their duties in that regard.
How about the firm’s own management structure? Is there a clear allocation of senior level responsibility for the management of regulatory risk? The firm may have a head of compliance, or general counsel and, if so, they will be in charge of a range of regulatory issues. But does the board know what the most salient risks are? Are these included in its risk register? Is it confident that a properly resourced team is adequately mitigating all material risks? Given that the range of such risks is ever-increasing – from MiFID II, through GDPR and tax avoidance, to anti-corruption and modern slavery – it is essential that the leadership team is actively monitoring their management. Regular reports to the board, accompanied where appropriate by compliance audits and KPIs, should be regarded as a minimum requirement for regulatory risks that are identified as material to the business.
Many private equity firms are already at the forefront of good corporate governance, both as regards their portfolio companies and for the GP itself. But – in an industry that is committed to continuous improvement – it may be an opportune moment to reflect on current structures and practices. Corporate governance is certainly topical at the moment, and will remain an area of focus for regulators and investors alike.
by Simon Witney,
Special Counsel, Debevoise & Plimpton
Among other things, effective corporate governance requires:
- mechanisms that optimize the decision-making process, including processes to harness appropriate expertise, ensure board members are well-informed and free from conflicts, engage in constructive challenge and avoid group-think.
- identify and actively manage all business risks, including reputational and compliance risks.
- ensure that all key stakeholders are represented in the process, or that their views are understood and considered by decision-makers.